Manulife Earnings Hurt By Weak Asia Performance But Higher Rates Will Help

Manulife (NYSE:MFC) reported net income of C$259 million for the second quarter of 2013, compared with a net loss of C$281 million last year. The top-line results were below expectations mostly due to market related charges totaling $291 million of which the company expects $118 million to be reversed in the coming quarters. Manulife’s core earnings, which exclude the effects of certain one-time charges, grew 2% over the prior year with a near 40% increase in earnings from Canada and a 12% increase in the U.S.

The recent surge in bond yields is expected to benefit the company, which has half of its assets invested in bonds. Manulife’s yield from bonds dropped from 5.14% in 2007 to 3.85% in 2012. However, recent improvements in the job market have raised speculation that Federal Reserve’s Quantitative Easing program might be coming to and end. The program has been keeping interest rates artificially low by purchasing assets like long dated treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term interest rates.

The Fed has indicated a threshold of 6.5% unemployment rate as a target for the economic recovery before it might start increasing interest rates. [1] The unemployment rate in the U.S. has recovered from 10.1% observed during the financial crisis in 2009 and reached a four-year low of 7.5% in April, staying around 7.6% through May and June before increasing marginally in July. [2]

The 10-year Treasury bond yield has climbed from 1.66% in May to 2.63%. [3] The 10-year Treasury bond yield was around 5.5% in 2007, more than double the current yield. The Canadian Government 10-year bond yield, which is highly correlated with its U.S. counterpart, increased from 1.68% to 2.55% in the same period. [4] Around 25% of Manulife’s assets are invested in government and corporate bonds each. Given the recent trends, we have updated our forecast for Manulife’s yield from fixed maturity investments. We expect the yield to reach the pre-recession level of 5% in the next two years and reach around 5.5% in the following years.

Investment income accounts for 32% of Manulife’s revenue but is also very important for the insurer’s margins. Companies collect premiums from clients in exchange for coverage, and the income from these premiums is invested, primarily in “safe” securities like government and corporate bonds, to generate returns for the company. By generating higher yields from its investments, Manulife will also be able to realize higher margins in its insurance operations.

We have updated our model to account for this increase. We now have a price estimate of $17 for Manulife’s stock, in-line with the current market price.

Asia Disappoints

Asian core earnings declined 21% over the prior year as a result of a 31% decline in insurance sales in the continent. Asian sales were below par mainly due to the non-recurrence of key tax related event in Japan which drove sales in 2012. The depreciating Yen also had an adverse effect on the Manulife’s earnings from Asia. Nearly half of the company’s Asian insurance sales and 30% of its wealth management product sales come from Japan.

Despite the decline in sales in Asia this year, we remain optimistic about Manulife’s prospects in the region. The company has operations in Japan, China, Hong Kong, Thailand, Malaysia, Indonesia, Singapore and Philippines, accounting for one-third of the company’s insurance premiums. Manulife’s market share has increased substantially in the last few years and the company now accounts for nearly 1% of the entire continents insurance market.

As mentioned before, Japan is the fulcrum for Manulife’s Asian operations. Manulife Japan has around $30 billion in assets under management with over 1,300 employees and a distribution network of 2,900 agents. The company has around 1 million policies in force in the country with a market share of 2.2% in terms of new business annual premium equivalent (APE) and 1% in terms of in-force APE. Manulife is particularly strong in the Managing General Agents distribution channel, with a 6.5% market share. [5] The channel provides insurance services through independent agents via walk-in insurance shops.

Manulife recently announced the sale of its Taiwan operations to CTBC Insurance for an undisclosed amount. The transaction is not expected to have a material impact on results. [6] We are lowering our forecast for Manulife’s share of the Asian market for the current year, but expect the company to remain on track for future growth in the coming years.

Canada And U.S. Perform Strongly

In its home turf, the Canadian insurer reported a 26% increase in core earnings with a 26% increase in wealth product sales helped by record mutual fund sales. Insurance sales increased 19% over the prior year, driven by strong group benefit sales which offset a marginal decline in individual insurance sales. Manulife has taken some strong pricing measures in the country to offset low returns from investments, which have hurt its share in the individual insurance market. Taking into account that its competitors like Great-West Lifeco., Sun Life Financial and Desjardins Financial Security have not taken actions of similar magnitude, the company has done particularly well to maintain sales growth in the Canadian market.

Manulife’s market share dropped from 13% in 2008 to 6.5% at the end of 2011, we expect the company to consolidate its position in the coming years.

In the U.S., Manulife reported a 58% year on year increase in wealth product sales, again driven by record mutual fund sales. Insurance sales were in-line with the prior year’s figure as Long-Term Care and Life Insurance products performed strongly. The company also announced an agreement with Symetra Financial Corp. to acquire Symetra Investment. The deal will lead to a 15% increase in advisers for the John Hancock financial network.

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